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Are annuities a worthwhile investment option?

Dr. Don TaylorDear Dr. Don,
Is an annuity a good investment? -- Genevieve Guarantee

Dear Genevieve,
Annuities are investment products that have an insurance component and are backed by the financial strength of the insurance company that structures the investment.

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The name comes from the investor's ability to convert the investment into a stream of periodic income payments (an annuity) either over the annuitant's life or a set number of years. Conservative investors like the idea of an annuity because they like the certainty of an income stream over their life expectancy.

Annuities offer a measure of protection against market downturns, may provide a guaranteed investment return, and grow tax-sheltered until you withdraw the money. They are, however, seldom the right choice for tax-advantaged retirement accounts like 401(k) plans or IRA accounts.

There are fixed annuities and variable annuities. In general, the return on a fixed annuity is contractual during both the accumulation phase (contributing to the account) and the annuitization phase (taking contributions from the account). That's why it's called a fixed annuity. It doesn't mean that the rate can't vary over time; it means that how the rate changes is stipulated in the annuity contract.

With a variable annuity you invest in sub-accounts during the accumulation phase. The investment return depends on the investment performance of the sub-accounts you choose. Your choices in sub-accounts mimic the choices you would have in a family of mutual funds.

Variable annuities are often expensive investments to own. You pay for the insurance component, called mortality and expense risk charge (M&E). The average annual M&E charge on an annuity is about 1.15 percent.

The variable annuity sub-accounts also have investment administration expenses. These annual expense ratios vary depending on the sub-account, but .45 percent to 1.25 percent isn't uncommon. You can easily wind up paying up to 2 percent annually on M&E and investment management fees. That creates a drag on the variable annuity's investment return.

Annuities also have surrender charges if you withdraw your money from the account in the first six to eight years. The surrender charges are typically 6 percent to 8 percent in the first few years and decline over time to 0 percent. If you change your mind about investing in the annuity, you could pay a steep price to get out of it.

A Tax-free Section 1035 exchange will allow you to move from one annuity to another without a tax effect, but you can't avoid surrender charges by making a Section 1035 exchange.

Some annuity providers offer bonuses as an incentive to get you to transfer to their variable annuity product. The logic is that they are compensating you for the surrender charges you'll have to pay in getting out of your existing annuity. The downside is that you'll start all over with a new surrender period for the new annuity, and the charges and terms of the new annuity may be more expensive than the original annuity.

The Securities and Exchange Commission has a very good online brochure concerning variable annuities. Investors considering purchasing a variable annuity should be sure to read this publication before starting to shop for a variable annuity.

Readers interested in learning more about fixed annuities can find additional information on Annuity.com or Insure.com. Talk to your tax professional before investing in any annuity contract, and make sure you understand the annuity's annual fees and expenses before investing.

Most long-term investors don't need the insurance feature of annuity investments and would be better off in other investments. The basic insurance feature guarantees that you won't lose money due to market downturns by investing in a variable annuity. The longer you own the variable annuity, the less likely it is that you will lose all your investment gains and benefit from the insurance provisions.

The stock market's performance over the past two years has reminded investors that stock prices can go down as well as up, but paying M&E expenses over time hurts your investment's average annual return. Most investors would be better off considering annuities as a last resort rather than a first choice when it comes to creating an investment portfolio.

-- Posted: April 11, 2002




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